Friday, October 10, 2008

The 2008 Federal Reserve Tightening

Throughout the first half of 2008 most market commentators declared that the Federal Reserve was in an easing posture. In fact, with fed funds at 2 percent, many declared that they were in the process of contributing to the next inflationary binge.

Fed Funds are a Poor Indicator of Ease or Tightening

It is misleading to use the federal funds rate to judge the degree of Fed ease or tightening, or even whether they are easing or tightening. Why? Because, as I explain in the monograph I keep referring to, while the market is watching the fed apparently ease by lowering the funds rate, the Fed in reality is sometimes managing to reduce the level of reserves in the banking system at the same time.

To understand this, to even believe that it's possible, you have to understand the Strong Form of Monetary Theory that I've discussed in previous posts, and in the monograph. As I've explained, one of the best (though still not even close to 100% reliable) indicators of the true Fed policy is the trend in demand deposits balances.

Demand Deposits in 2008

If you go to the Federal Reserve's H.6 Release for August 28, 2008 and scroll down to Table 3 titled Seasonally Adjusted Components of M1 you can view the level of demand deposits on a weekly basis (seasonally adjusted) for the past year and a half. Note that in April of 2007 demand deposits were at $305.9bn and that by May of 2008 they had fallen to only $288.4bn. This occurred while the Fed was supposedly easing.

Was this merely one of those times when banks were finding ways to utilize deposits more efficiently, so that the system wasn't really contracting? Well, look at Currency on the same chart. It peaked at $761.5bn in October of 2007 and then stopped growing, or even fell modestly, until April of 2008. This never happens. Currency always grows at a fairly steady rate due to the past increases in the general price level, i.e., due to the public's need to catch up with past inflation. So, yes, monetary policy was tight for the last half of 2007 and the first half of 2008.

Confirming Evidence of Monetary Tightness

Note how the consumer expenditures in the GDP figures have started to be revised downward all the way back to the fourth quarter of 2007, revisions that are completely consistent with a monetary contraction beginning around the second quarter of 2007. Note also the reversal of the commodity bubbles around the world, the continuing fall in housing prices, and the steady rise in the stock market came to an end by the third quarter of 2007. All of this is consistent with a monetary contraction beginning in the second quarter of 2007, as explained in the monograph.

Finally, note the carnage in the stock market, the contraction of global credit and the sudden strengthening in the dollar over the past several weeks as the world's investors come to grips with the reality that we are deflating, rather than inflating.

Finally, an Easing of Policy, and What an Easing!

Now look at the current Federal Reserve H.6 report. Note that Demand Deposits, seasonally adjusted, have exploded in September, reaching just over $400bn in the September 29th week, an increase over trend of more than $100bn!

It's not a String the Fed is Pushing On; It's an Iron Bar

Again, you need to read the monograph to understand this. In any case, if you go to this link to the Federal Reserve's current H.3 Release and look at the Excess Reserves column in Table 1, you will see that after running just below $2bn for the entire year, excess reserves have now exploded to nearly $70bn in late September and to $136Bn in early October! This is exactly what has caused the huge increase in demand deposits.

If ever there was an economic environment where the "pushing on a string" theory would seem applicable, this would certainly be it. Yet demand deposit growth, i.e., money supply growth, has ballooned at a rate never before seen (though we came close at the turn of the century and also after the 9/11 terrorist attack.) It's not a string, it's more of an iron bar.

The Implications for the Markets

Suddenly we have a banking system awash in demand deposits, housing prices have already adjusted downwards significantly, the gas price surge that caused U.S. consumers to reduce other spending has reversed dramatically and stocks are at values not seen since the 1980 bear market.

In the meantime, Treasury Bonds are near all-time low yields offering only security, but certainly not yield, and we are about to enter an inflationary era not seen since the 1970's if the Fed stays on this course.

But how can stocks rally when there are no buyers, you ask? Well, it will probably happen when people holding long-term treasury bonds come to the conclusion that they're now holding the riskiest asset in the game and try to shift some of their assets to the stock market. After all, stocks are a far better long-term investment in an inflationary environment that are long-term bonds.

Next, I'll discuss how our inept government is on the verge of converting the extremely useful "iron bar" to that limp "string" everyone is always talking about. Really. That's what's in the works, and it's important that we understand the implications.

Sunday, October 5, 2008

Monetary Policy, Pushing on a String - Not!

Two Schools of Thought about Monetary Policy Theory

How does the Federal Reserve influence interest rates, economic activity and the inflation rate? There are two schools of thought in this regard, one I call the weak form and the other I call the strong form of monetary policy theory. Note that I'm not addressing just monetary policy here, but the theory behind the policy.

The Weak Form

What I consider the weak form of monetary policy theory is the version where the chain of events goes thus:

1. The Fed eases by lowering the federal funds rate in the interbank market.

2. The lower fed funds rate causes other short-term rates to fall as well.

3. As the front end of the yield curve moves lower, businesses and individuals begin to take on more credit.

4. The increase in borrowing (and the associated increase in purchasing) generates an increase in economic activity.

5. Eventually, if rates are held too low for too long, the increase in economic activity generates inflationary pressures and pressure grows for the Fed to reverse course and begin raising the federal funds rate.

This is the way the world is viewed by most investors and commentators. The editorial page of the Wall Street Journal, for instance, espouses this theory. The weak form also leads to the old "pushing on a string" analogy of monetary policy. The assumption is that things can be so bad that the action of lowering interest rates does not induce any additional business activity (step 3, above) and so the economy remains stagnant. This belief also leads some economists to advise politicians that the only way to get things moving again is to spend some government money, i.e., to introduce some fiscal stimulus. Well, we tried that this year once already and it failed. Unfortunately, under the weak form of the theory our only available option is to do more fiscal stimulus. As before, it just won't work.

The Strong Form

Here, in what I call the strong form of monetary policy theory, is what I'm nearly certain actually occurs during an easing of policy.

1. The Fed, possibly inadvertently, adds sufficient excess reserves to the banking system to get reserves circulating furiously, driving down the federal funds rate at the end of the reserve calculation period. During this process, the average federal funds rate does not have to even be falling and might, in fact, even be rising.

2. If the Fed repeats this process for more than two reserve calculation periods, the excess fed funds being circulated in the banking system are forced into the money supply via other business and individual banking transactions. Again, this process might be planned by the Fed, or inadvertent. If inadvertent, the average fed funds rate is probably stable or even rising.

3. The pressure of the excessive money creation, if sustained for more than two reserve calculation periods, finds its way into the securities markets, particularly the stock market, causing an almost immediate rally in equity prices.

4. Once the increase in money supply has been generated the Fed institutionalizes it, probably inadvertently, by supplying the necessary reserves in future reserve calculation periods to support the now-higher money supply.

5. Along with the increase in securities prices, particularly stocks, other economic activity also begins to accelerate, but the lags are such that the reported increase in such activity only begins to appear approximately six months later.

6. Virtually all increases in the level of the money supply, properly defined, eventually cause a corresponding increase in the general level of prices, i.e., the inflation rate.

Now, under the strong form of the theory, increases in excess reserves, even though provided only intermittently and possibly even during a period of perceived tightening, generate increased money flows in the economy, reflected in immediate stock market improvement, an improvement in the economy reported with a six-month lag and an increase in the general price level that occurs, and is reported, over a period of several years.

Under the strong form, the Fed drives economic activity short term and tax policy and other government policies regarding regulation, etc., drive economic activity over the long term. Also, under the strong form, the level of interest rates is nearly irrelevant to the process, and fiscal stimulus is almost certainly counter-productive given that it sucks resources from the far more productive private sectors of the economy.

Read the Monograph to Better Understand How This Can Happen

As I explained in A Strong Form of Monetary Policy on September 20th, you should read A Monograph on Monetary Policy to better understand the complete picture of what I'm saying and to understand why I can assert the following:

It is possible, under the Strong Form of Monetary Policy Theory that I describe here, for the Federal Reserve to actually be tightening, i.e., causing reduced economic activity and lowering the overall price level, even though they are lowering the federal funds rate in the interbank market.

This can happen simply because the Fed can make, and does make, an occasional mistake in providing the necessary reserves to the banking system in any given reserve calculation period. That is, to take the current time frame, even though they have lowered the average funds rate over a period of months, they might have underestimated how many reserves were needed several times during those months.

Thus, even though the Fed intervenes in the market when the funds rate rises just a bit, thereby convincing the market participants that the Fed wants rates to be lower, they might inadvertently inject too few funds to satisfy reserve requirements for the entire reserve period. This mistake only shows up late in the reserve calculation period when individual banks realize they are short reserves and the calculation period is coming to a close. If this happens system wide, the scramble for the needed reserves results in a one-day escalation in the funds rate, sometimes a severe escalation. Yet, the next day begins a new calculation period and with the Fed again intervening at the expected low rate, everything settles back down.

The reason it takes several weeks for the pressures to escape into the other financial markets is that banks can carry forward a reserve deficit or surplus for one period, but not two periods. During the first period of tightness, the reserve desk managers hold off paying an excessive rate for fed funds because they can cover the shortage the following reserve period. However, they can't do this the second period and so the rate skyrockets as the system scrambles for fed funds that are not there in aggregate. All this while, the Fed, and most participants and observers, think the Fed is in an easing posture.

Has the Fed Really Been Easing in 2008?

I don't think so. In fact, I think 2008 could be characterized as a period of monetary tightening, under the strong form interpretation, a case that I will make in the next post.

Next Post: The 2008 Federal Reserve Tightening